One of the big events for me this week was the alteration the Fed made in their statement from the September meeting, and I think it will help provide a huge advantage in trading.
Unlike the single-mandate European Central Bank, which is responsible only for maintaining price stability (controlling inflation), the Fed has what’s called a “dual mandate” in that it’s responsible for boosting jobs and while controlling inflation. We know this to be the case because the legislation which created the Federal Reserve System specifically said its job was “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Of course, as we’ve seen over the last 2 years or so, there’s another function which the Fed and all Central Banks are ultimately responsible for; the stability of the financial system.
In any event, the Fed was kind enough to enunciate exactly what the market is to look for when anticipating the inevitable increase in interest rates. Here’s what they said in September:
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
Here’s the November alteration:
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” (Emphasis mine).
Resource utilization has to do with the gap between potential and actual output (GDP), but what it really refers to is the first part of the dual mandate, employment. What this means is that a stable trend of job creation will need to be seen before interest rates can begin to normalize, which is exactly what happened after the 2001 recession when job creation did not begin until well into 2003 and the Fed didn’t start to normalize policy until early 2004.
Subdued inflation trends is specific to the rate of inflation as measure by core PCE (Personal Consumption Expenditures), which the Fed looks to maintain at a rate between about 1.8% to 2.0%. This number has been falling all year and is currently just 1.3% in the year to September (latest release).
Inflation expectations are garnered by surveys (such as the Michigan survey of consumer confidence) and by looking at the spreads between similar maturity regular (nominal) Treasuries and Treasury Inflation Protected Securities (TIPS).
To that go here: http://www.bloomberg.com/markets/rates/index.html
For example, subtract the 5 year nominal rate from the 5 year TIPS rate. The difference is investors’ expectation for overall inflation during the term (currently around a very low 1.8%). If that rises it means that investors are expecting inflation to increase, which is something the Fed looks at according to the statement.
So, what everyone has the chance to do now is to become a junior FOMC member and apply this to your trading. And since employment, inflation and inflation expectations are not set to rise for many months what we can expect to see are exceptionally low levels of the federal funds rate for an extended period, which means an appreciating stock market and a depreciating dollar. For now, the trend is intact and the play is to buy on the dips and sell on the tips.